What John Carney At Breitbart Gets Wrong About Trade Deficits

John Carney decides to school us all about the trade deficit and desires to use something a little more than just three weeks of Econ 101 to do so. Good, that's excellent, it's just great to see a slightly more sophisticated chat about trade, one that's better than just trade deficits are bigly bad. Sadly, Carney manages to not quite go far enough in his discussions about this. It's necessary to go through more than just one, or even two, iterations of the money changing hands in order to grasp what is happening. That being the thing that he doesn't.

Don Boudreaux is also not happy with Carney's description and you know if that's happening then there's an error or more in the explanation:

John Carney’s essay “No. The U.S. Trade Deficit Is Not a Good Thing” (Aug. 15) is a fusillade of fallacies. Among the worst is Mr. Carney’s claim that foreign direct investment “isn’t some vote of confidence in the health of the American economy. It’s just a side-effect of the fact that our deficit leaves the world with excess dollars.”

The U.S. trade deficit arises when foreigners, who earn dollars selling their exports to Americans, invest some of those dollars in America rather than spend those dollars on American exports. If foreigners had no confidence in the American economy, they would, as quickly as possible, cash out their dollars for American goods and services rather than put those dollars at risk in dollar-denominated investments. Therefore, by investing in America, foreigners do in fact cast a “vote of confidence in the American economy.”

Quite so. And I would take this one stage further, a stage that Boudreaux doesn't. Don being far too polite to try to put across an idea he thinks someone might not be able to understand.

In ridiculing Sen. James Lankford’s optimistic assessment of the U.S. trade deficit, Mr. Carney accuses the senator of having “a kind of dorm room, first three weeks of a freshman taking Economics 101 understanding on international trade and capital flows.” In fact, the one whose understanding of economics and capital flows is sophomoric and faulty is Mr. Carney.

Earlier, I mentioned that the standard economics view of the fate of foreign dollar savings is “not quite right.” According to that view, dollars accumulated by foreigners must as a matter of logic eventually be spent on goods and services made in the U.S.

Yes, this is true, but Carney wants to tell us that it is not so:

Otherwise, foreigners would be selling us real things–cars, computers, call center operations–in exchange for nothing but paper: dollars, Treasuries, stocks. So unless foreigners are irrationally giving us stuff for free, they must really be accumulating dollars because they plan to buy stuff with dollars. Even if they plan to spend dollars on stuff made by other foreigners, then those folks must eventually want to buy stuff from us. Under this view, eventually our trade deficit will become a surplus as those dollars get used to buy stuff made in the U.S.

But this is too neat. It is a bit like financial economists who insist that stock prices reflect future dividends and then have to assume that stocks that pay no dividends eventually will. There’s no law of economics that says financial assets such as dollars and Treasuries cannot be accumulated without any plans to spend them on real goods. Dollars have an optionality, a call-value that is extinguished when they are spent. In the face of uncertainty about the future, it is rational for actors to preserve this optionality rather than extinguish it. And since the value of this optionality extends to subsequent generations–this of wealthy people who keep earning more than they can ever spend–that’s not necessarily the end to it. Which mean that so long as the future remains uncertain — until kingdom come — trade deficits can persist into eternity.

Err, no, that's not the point being made at all.

I have absolutely no doubt at all that Carney agrees that the trade deficit (OK, actually the current account one) is always going to be exactly offset by the capital account surplus--that balance of payments does balance after all. For my part I'm entirely happy to agree that there's an option value to a dollar. Even an option value to parking the money in a Treasury or a stock. Excellent, but we've got to track the money more than just the one or two iterations that Carney does.

The first iteration is that the money's in Carney's pocket, a good red blooded American and that money's thus as Yankee as Mom's Pie. He then spends it on some piece of Chinese electronic tchotchke and off that dollar goes to J. Foreigner. We both agree that it's going to come back, assuming there's a trade deficit, as part of the capital surplus. Great, Carney is now saying that the spending of that dollar on some US capital thingammiebob just pushes up the prices of thingammiebobs and doesn't do the US economy any good. That's looking at only two iterations of the money exchange, we need to look at the third.

Mr. J. Foreigner has spent a dollar on some capital asset in the US. Maybe it is only a Treasury and maybe it will only be held for its option value. But who has the dollar now? Whoever sold the Treasury. If it's a new one then the US government has the dollar and as we know they spend the heck out of dollars into the US economy. Mr. J. Foreigner's dollar is now back home and is as American again as Mom's Pie. Maybe it's not a new Treasury, it's an old one. Well, someone sold it so someone got that $ for it. That someone selling might be Ms. J. Foreigner, might be J. Sixpack. In that second case then our $ is repatriated again, in the first we've just got to go to the fourth, fifth, sixth, iteration in order to get back to that dollar re-entering the US economy. Because, at heart, and somewhere down the line, only an American can sell, for the first time, a US asset.

And when an American--and this is true of a company selling stock, the government selling Treasuries and secondary investors in any of these--sells an asset then the American has only three things he can do with the $ he receives. He can invest that money, spend it in the domestic American economy or buy an import--at which point the whole rigmarole starts again. This is true of second hand stocks and bonds, new ones, of property, of houses, of everything.

That is, we're not saying that all dollars must come back just because someone parks it on Wall Street. Rather, they've got to, when parking it on Wall Street, buy it from someone. And as long as we go through enough iterations we'll find an American doing the selling. That American then has that $ back in the American economy and that's how it all comes back.

Further, do note that we can do this forever. For the US creates new financial wealth of just this kind faster than the size of the trade deficit. US financial wealth is rising at something like $2 trillion a quarter these days. The trade deficit is about $500 billion a year. That is, Americans can carry on selling this newly created financial wealth to foreigners, thus repatriating those dollars, forever and the foreigners end up owning a smaller percentage of American wealth over time.

As John Carney at Breitbart fails to recognise, the dollars of the trade deficit really do come back into the US economy, they must do, and it's real Americans who get their hands on them when they do.

I'm a Fellow at the Adam Smith Institute in London, a writer here and there on this and that and strangely, one of the global experts on the metal scandium, one of the rare earths. An odd thing to be but someone does have to be such and in this flavour of our universe I am. ...